IT opinion: Why are investment trusts taking a turn for the defensive?

Last year was a good one for investment trusts in absolute terms, albeit the sector slightly lagged the rise for the wider market. The FTSE Equity Investment Instruments index, which comprises all the investment trust companies that are constituents of the FTSE All Share, was up 16.6 per cent on a total return basis compared with a rise of 16.8 per cent for the FTSE All Share. This compares with a rise of 5.2 per cent in 2015 when the sector outperformed the wider market, which was up just 1 per cent.

The long-term performance of the sector remains strong, up 91 per cent over the past 10 years compared with 72 per cent for the FTSE All Share. Investment trusts have outperformed the wider UK market in six of the last 10 calendar years, and were ahead in four of the last seven years. Two of the four years of underperformance have coincided with market falls, which might be expected given the use of gearing and the tendency of discounts to widen in difficult market conditions. Conversely, trusts have traditionally tended to perform well in rising markets due to the same factors.

However, we believe the sector is becoming more defensive, reflecting the changing nature of the investment trust universe. For the past few years fundraising has been dominated by non-equity, specialist funds that offer uncorrelated income.

These funds reduce the beta of the sector and we estimate that at the end of 2016, 37 per cent of the sector’s assets were exposed to non-equity asset classes compared with 25 per cent 10 years earlier.

The sector average discount (excluding private equity, direct property and fund of hedge funds) ended the year at 5.7 per cent, compared with 4.4 per cent 12 months earlier. During the year, the average discount was 6.7 per cent compared with an average of 5.6 per cent for 2015. Discounts widened markedly in the first quarter of last year as market volatility rose and retail investors became wary on the outlook for equities. After partially recovering, discounts were impacted by the Brexit vote, although the effect was short-lived. The final quarter saw discounts tighten further as the market rallied with the “Trump bump”.

It was a mixed picture for discount movements by subsectors in 2016. Europe and UK Small Cap saw the greatest discount widening, particularly after the EU referendum. More defensive sectors were in favour, with UK Property and Flexible Investment seeing the greatest re-rating. Private Equity also fared well last year, largely as a result of corporate activity with an unsolicited bid for SVG Capital. The US subsector was re-rated following the US election in November.

Demand from retail investors for equity funds weakened in 2016, which was reflected in the widening discount for the UK Equity Income sector. UK Small Cap was de-rated in the year, with Brexit leading to another leg down in its discount level.

The discount for the Global sector was volatile, reflecting market conditions, while discounts for Emerging Markets and Asia ex Japan remained wide, due to their continuing out-of-favour nature, despite a pick-up in performance.

The best investment trust sector perfor-mer in 2016 in terms of market cap weighted share price performance was Commodity (up 77 per cent) followed by North American Income (up 53 per cent) and Emerging Europe (up 45 per cent), while the worst performer was UK Small Cap (down 3 per cent) followed by Peer to Peer Lending (down 1 per cent).

The best-performing investment trust in share price terms in 2016 was Industrial Multi Property (up 104 per cent) followed by BlackRock World Mining* (up 101 per cent). Funds exposed to resources did well in general, including Baker Steel Resources (up 98 per cent) and Golden Prospect (up 98 per cent). The worst-performing fund last year was Candover Investments* (down 56 per cent) followed by Kennedy Wilson Europe (down 17 per cent).